Edward G Smith and Jan M. Smith - Page 9

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          Relying on the foregoing regulations, respondent determined that            
          the flooring materials that Smith Floors purchased and installed            
          during 1995 were merchandise, that such merchandise was an                  
          income-producing factor, and that Smith Floors therefore must use           
          the accrual method of accounting to clearly reflect its income.             
               Petitioners contend that Smith Floors is a service provider            
          and that it purchases flooring materials solely as an                       
          accommodation to those contracting for its services.  Therefore,            
          petitioners contend that Smith Floors’ use of the cash method of            
          accounting is proper.                                                       
               Whether Smith Floors must use the accrual method of                    
          accounting instead of the cash method depends on whether Smith              
          Floors is in the business of selling merchandise (within the                
          meaning of sec. 1.471-1, Income Tax Regs.) to customers in                  
          addition to providing flooring installation services or whether             
          the flooring material provided by Smith Floors is a supply that             
          is incidental to Smith Floors installation services.                        
               The term “merchandise” is not defined in either the Internal           
          Revenue Code or the regulations.  See RACMP Enters., Inc. v.                
          Commissioner, 114 T.C. 211, 221 (2000).  To resolve whether                 
          particular materials constitute merchandise, we look to the                 
          context in which the materials are used.  See id.  The high cost            
          of materials relative to labor costs is insufficient, standing              
          alone, to transform the sale of a service to the sale of                    

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